When is the right time to make a tax-efficient gift?

Most tax exemptions are capped for each tax year, but the inheritance tax gifts-out-of-income exemption is different. How can you make the most of it? 

IHT exemptions

Compared to income tax and capital gains tax, inheritance tax (IHT) has a rather meagre annual exemption of just £3,000. This is the maximum you can give away without eating into your nil rate band. Perhaps that’s why some people turn to complex IHT saving schemes, but if you go down that path, you should consider an IHT exemption that’s often overlooked.

Income exemption

A gift out of income is completely exempt from IHT no matter how much you give away, whereas gifts of capital, to the extent they total more than £3,000 per tax year, potentially increase the IHT bill on your estate. However, deciding whether a gift is one of income or capital isn’t straightforward.

Surplus income condition

A gift only counts as IHT exempt where it comes from income left over after you’ve paid your normal living costs, e.g. food bills, domestic costs, etc. However, it’s no use reducing these costs so you can make IHT-exempt gifts of income, HMRC won’t accept this. You can’t, for example, give away your entire salary to pay for university fees and then dig into your savings to provide for yourself.

A pattern of gifts

There’s also another condition to the exemption. Generally speaking, a one-off gift out of your income won’t qualify. The exemption only applies to gifts where they are made habitually. There’s no definition of this in law, but it’s accepted that a series of gifts made over three years is enough to create an habitual pattern. 

What are the time limits

The good news is that the gifts-out-of-income exemption isn’t tied to the tax year. Gifts made after the end of a tax year can still qualify. HMRC will usually look at a rolling period of two years. However, you can’t save income indefinitely.

Trap. Unspent income that accumulates, e.g. sits idly in your bank account, becomes capital after a couple of years. If you give it away HMRC won’t accept the gifts-out-of-income exemption applies. 

Tip . It’s important to keep good records of gifts you make and let the executors of your will know where these are as, in the event of your death, they might be needed to prove the exemption applies. 

Getting the exemption sooner

While normally a pattern of gifts must exist before the exemption applies you can shortcut this simply by showing that it’s your intention to make regular gifts.

Tip. Send a letter to those you will make gifts to saying that you intend to give them some or all of your excess income each year. Alternatively, agree to pay a regular expense of theirs, for example their child’s school fees or take out a saving plan that requires regular investment, such as an insurance bond. 

Start planning early with IHT, you will save yourself and your family thousands and a great deal of heartache by doing so! 

Happy tax saving! 



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